The new regulations imposed on money market funds lastfall triggered a huge migration of assets out of institutional prime funds.And three months after the changes took effect, institutionalinvestors still seem to be wary of heading back into primefunds.

More than $1 trillion in assets exited institutional prime fundsafter the Securities and Exchange Commission said in 2014 that asof mid-October 2016, the funds had to float their net asset value (NAV) and establish redemption fees and gates. By the start of November,just $122.1 billion remained in institutional prime funds, downfrom $779.2 billion at the start of 2016, according to statisticsfrom the Investment Company Institute. With the exception of abrief move higher around year-end, the total assets ininstitutional prime funds haven't increased much; last week's ICIdata showed $129.6 billion in prime funds as of Jan. 11.

Most of the money that left prime funds headed into governmentfunds, which are not required to float their NAVs or impose feesand gates. Institutional government funds, which held $868.6billion in assets at the start of 2016, ended the year with $1.616trillion.

The huge shift in assets was accomplished smoothly, whichanalysts credit to prime funds' having maintained high levels ofliquidity in order to accommodate investors' redemptions, as wellas to government funds' ability to turn to the Federal Reserve'sreverse repo program if they had a hard time finding enoughgovernment securities.

“The industry did a really effective job of anticipating theoutflows and making sure they had sufficient liquidity,” said RogerMerritt, a managing director at Fitch Ratings.

In the months since the implementation deadline, institutionalprime funds have reversed the defensive positions, includingshorter durations, that they took in the fall.

Funds' liquidity ratios are key under the new SEC rules, whichmandate that if a fund's ratio slips below 30%, it is subject tofees or gates. Greg Fayvilevich, a senior director at FitchRatings, noted that heading into the October implementation of thenew rules, some prime funds were maintaining weekly liquiditylevels as high as 100%.

“Since then, that has gone down,” he said. “We're still seeinglevels of liquidity that are higher than historical normspre-reform, but they're certainly down.

“Now some are managing around 40% weekly liquidity,” he said,noting that that level provides some cushion above the 30% levelinvestors will be watching for.

The other big change, in addition to the possibility ofredemption fees and gates, was prime institutional funds' adoptionof floating net asset values, instead of the constant NAV of $1they offered prior to the SEC's reforms. But prime funds' net assetvalues have been “remarkably stable” since NAVs began floating lastfall, said Mark Cabana, head of U.S. short rates strategy at Bankof America Merrill Lynch.

“Just looking at some data from Crane [Data], it really seemslike the average [NAV] level across prime institutional funds hasstayed above $1 per share and really has not fluctuated all thatmuch since they started floating,” Cabana said.

Those steady NAVs seem as though they should be reassuring toinvestors. And many analysts had predicted that while institutionalinvestors were likely to exit prime funds ahead of theimplementation of the new rules, they would start moving assetsback into prime funds once the yield spread over government fundsgot to an attractive level. That spread has widened, but so far,investors aren't heading back to prime funds.

Yield Advantage

Cabana cited iMoneyNet data showing that institutional primefunds are yielding about 87 basis points, which is 34 basis pointsmore than institutional government funds. “That differential haswidened as rates have moved higher and as the yields that have beenoffered on commercial paper and CDs have increased given thesmaller overall investor base that participates in primeinstitutional funds,” he said.

He noted that a survey conducted by Bank of America MerrillLynch last year about what investors expected to do in the twoyears after the rule changes showed respondents thought a yieldpickup of 30 to 40 basis points would be attractive enough to lurethem back into prime funds.

Cabana expects the yield spread to continue to widen over thefirst half of the year, and predicted that some investors will“think about moving back into prime funds or at least moving backinto other alternatives that could enhance their yields, such asshort-duration funds or enhanced cash funds.”

He said, though, that he doesn't expect “a really dramaticshift” from government funds to other investments. “But it wouldn'tsurprise me if over time we saw 10% or 20% of what has beeninvested in government funds utilized to try to enhance yield inone form or another,” Cabana said.

Fitch Ratings' Merritt also expects that as the spread betweengovernment and prime funds continues to widen, some institutionalinvestors will move back into prime funds or other alternatives.But he noted that to do so, investors may need to rework their investment guidelines, aprocess that can take time.

“It is going to be a slow process of moving from government[funds] to something else,” Fitch's Fayvilevich said, citing thesmaller size of institutional prime funds as a factor. “Investorsgenerally would have limits in terms of how big the investor wantsto be as part of the fund,” he said. “So it may take an iterativeprocess until some prime funds are back to a bigger size.”

Lance Pan, director of investment research and strategy atCapital Advisors Group, noted one technical factor that couldaffect the spread between government and prime funds over the nextcouple of months: The U.S. debt ceiling is due to expire in March.If Congress delays renewing the debt ceiling, the Treasury may haveto limit issuance of Treasury bills, creating a shortfall insupply, a factor that would depress rates on bills and boost thespread.

“That may get some people back into prime funds,” Pan said. “Butit only works with the accounts that say, 'We are comfortable goingback into prime.'”

He argued that it's too soon to expect corporate treasurers tobe assessing a return to prime funds, and he predicted they won'tstart thinking about that until “at the earliest March.”

Pan added, “If you think about the calendar effect of whatcorporate treasurers do, I don't think the first 60 days [of theyear] anyone is focusing on cash investments. They're just tryingto get their financials done, and then they have their first boardmeeting.”

Other Options

Of course, if an institutional investor's main concern is yield,there are short-term investments that offer higher returns thanprime funds.

For example, ultrashort bond funds and private funds currentlyhave yields “quite a bit above” those on institutional prime funds,Fayvilevich said.

At last November's annual conference of the Association forFinancial Professionals, a survey of attendees at a session onmanaging liquidity in the wake of the SEC's reforms found 31% wereconsidering separately managed accounts, 19% FDIC-insured accounts, 15%money funds with floating NAVs, 14% ultrashort bond funds, and 12%direct investments, according to StoneCastle Cash Management.

Cabana cited short-duration bond funds and enhanced cash fundsas “two of the most compelling” alternatives to prime funds. “Theyoffer a little duration risk, the ability to move a little furtherout the curve with the expectation that there will be a bit morevolatility and price fluctuation but also greater reward,” hesaid.

Enhanced cash funds typically have duration ranges of six monthsto a year, while ultrashort bond funds range from six months to twoyears, Cabana said.

“These are not expected to fluctuate much, but the further outthe curve you go, the more volatility you could see,” he added.

Pan said he wasn't arguing for corporate investors to move backinto prime funds. He said they can easily realize higher yields byinvesting in securities that are a little further out on thecurve.

Investors should figure out how much of their short-term cashthey might need near-term and put that portion in government moneymarket funds, Pan suggested. Money that's not needed short-term canbe invested in a laddered bond portfolio in a separately managedaccount.

“Three-month Libor is over 1% now,” Pan said. “If you can takeyour liquidity risk out to 90 days or longer, you have your 1%right there.”

Corporate investors need to remember, though, that alternativeshort-term investments like ultrashort bond funds aren't regulatedas tightly as money market funds, and there's not as muchinformation available about them.

“The key consideration is to understand what you're investingin,” said Merritt. “There's not the same level of standardizationin what someone calls an ultrashort bond fund in terms of what theyinvest in and how far out the yield curve they go.”